MF portfolio construction – selecting the funds

We saw how to choose the categories of Mutual funds for your portfolio in the last post. While the categories can vary with individual situations, I do believe that the 4 types of funds along with an international fund will be the best way to go for most people. Remember that you are choosing the portfolio for long term investment and will be doing an annual review of it. So, the idea is not to get stuck in the process of selecting funds for long, but to decide on them and start investing.

Just to drive home the point, there are fundamentally 2 reasons for the 4-5 fund portfolio structure that I am suggesting. The first one is on coverage of the market. Stock performance can happen in any part of the market and you do not want to limit your participation to a narrow area. For example mid caps may have done quite well lately but you are unable to predict how they will keep performing in the long run. If you have only one mid cap fund then your portfolio lacks diversification and is therefore prone to more risk. Also, you may be giving up on serious growth opportunities in other parts of the market. The second reason for such a portfolio structure is the flexibility it gives you in investing. Read through my post again on the modified SIP way. With this portfolio structure you can vary your investments in each of the funds based on how that part of the market is performing at the given point of time.

With that out of the way, let us look at how you can arrive at the individual funds that you want to invest in. Even within the categories there are a plethora of options and most people get confused in trying to arrive at the “best” fund to invest. You will have many people coming up with calculators and historical data along with all kinds of ratios to help you in selecting a fund that is best for you. I find this is completely futile exercise for 2 reasons. Firstly, no matter what method you come up with, you are never going to be a match for professionals who are trained and do this for a living. Just like some random person cannot come and do your job better than you, so cannot you do it better than the people in the industry. There is no point in trying to reinvent the wheel. If you are suspicious of ratings then, by all means, try to understand how the rating has been arrived at. But honestly, I find it ridiculous that you open up an Excel sheet and populate with some data, hoping to find some magic deliverance though high flaunting financial jargon that has little meaning. A MF scheme will do well if it invests in the right stocks, no amount of Excel jugglery can tell you that.

The second reason why an involved exercise in choosing a MF scheme is meaningless is this – no matter how much data you analyse with whatever tools, it is all in the past. The MF itself warns you, of course prodded by SEBI, that you should not project future outlook based on past performance. So why would you even try to do that.This is also the reason why you should not look at the ratings from different websites as the gospel truth.

So how do you go about selecting the specific funds? The answer is amazingly simple and you just need to follow these steps below.

  • For each category look at the top rated funds from any website that you trust and whose rating methodology you understand. I have found VR online to be quite reliable but there are several other sites that will work too.
  • Make sure that the top ratings are not only determined by the last 1 year returns etc. So avoid settling for the Top 5 funds of the month etc. You are looking for long term investment and not just a short period bonanza.
  • Once you have made a shortlist of 3-4 funds in each category, you can narrow these down further by these:-
    • Reputation of the fund house. Ideally you should go for large ones that have been around for a long time. An exception can be a niche fund house, if you are convinced of their credentials. Personally, I have always been comfortable with Franklin, HDFC, ICICI and DSP BR.
    • Longevity and track record of the Fund manager. It will be nice to have a fund manager to have been with the fund for a long time, preferably 5 years plus. He should have also had a successful track record with this fund or earlier funds that he has managed.
    • The AUM of the fund. While this is not a definitive criteria, in general a larger AUM does provide a fair deal of flexibility to the Fund manager as to how he wants to deploy the money.
    • The trend of previous year returns, though this will generally be good for the top rated funds.
    • Check the current fund holdings to satisfy yourself that the fund is sticking to the mandate that it has. While all fund managers must have some leeway to improvise, you do not want to buy a large cap fund that is taking calls on mid cap stocks.
  • Repeat these for all categories of funds that you want to have in your portfolio. By this time you will have 1-2 funds in each category. Pick any one of those, it will not really make any meaningful difference if you have done the steps right. In any case, we will do an annual review to see how the funds are doing.

If you are already having a portfolio then I suggest you do 2 things immediately. Firstly, align your portfolio to the suggested portfolio structure that I wrote about in my earlier post. Secondly, do a basic check of whether you are in the right funds by checking these against the criteria mentioned in the above steps. If you see that you are not aligned in your portfolio or do not have the right funds make a change now. Loyalty is an admirable quality in life but not when you are selecting MF.

So we have now reached a point where you know how much you need to invest monthly ( from Goal based investing ), how should your portfolio be structured and what funds you are investing in. The next question to come up is how should you allocate your money to the different funds.

I will be answering that in my next post.

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